In the hustle and bustle of tax season, practitioners may overlook some of the elective tax benefits available to clients. Although many elections can be made under extension or on amended returns, a little forethought can go a long way. Here’s a follow-up to our June 2010 JofA article (“Tax Practice Corner: Don’t Neglect to Elect,” page 70) with more elections available to individual taxpayers. This time, we focus on investments, passive activities and other deductions and losses.
Electing out of deferral of gain in an installment sale. Installment sales of capital gain property generally require taxpayers to recognize gain as cash is received from the buyer. Usually, this method is advantageous for taxpayers, but not always. When capital gains tax rates are scheduled to increase in a future tax year (as they are as of this writing), or the taxpayer has enough losses or loss carryforwards available in the current tax year to significantly offset a large gain from the installment sale, the taxpayer may wish to recognize the entire gain in the year of sale.
The election under IRC § 453(d)(1) is made by simply reporting the full capital gain on a timely filed tax return for the year of the sale.
Accruing interest on U.S. savings bonds . Unlike with most other taxable bonds, cash-basis taxpayers can defer interest income from U.S. savings bond series E, EE and I until the bonds’ redemption, disposition or maturity. Redemption or maturity of several savings bonds in one year can create significant interest income, resulting in adverse tax consequences for taxpayers that may have little or no other taxable income and tax liability.
IRC § 454 and Treas. Reg. § 1.454-1(a)(1) enable cash-basis taxpayers to account for the savings bond interest on the accrual basis and report the interest earned each year on these savings bonds. Any individual or business entity may make this election by reporting as income the increase in redemption value and all interest accrued to date and not previously reported on the tax return for the year for which the election is effective. This election may also work well for savings bonds held in the name of a child whose total income is low enough that it is not taxable.
Practitioners should be aware that this election applies to all savings bonds owned by the taxpayer at the beginning of the tax year, as well as those purchased during the tax year and in the future. Taxpayers planning on redeeming these bonds to pay qualified higher educational expenses, excluding the proceeds from gross income in accordance with IRC § 135, should not make this election. Taxpayers can revoke the election and go back to deferring interest income until the year of redemption or maturity by attaching a statement to their tax return. This revocation can apply to savings bonds previously purchased but not to any yield income already reported in previous tax years.
Adjusting basis for unused passive activity credits. Upon the disposition of the taxpayer’s entire interest in a passive activity, a taxpayer can elect to increase the basis of property used in the activity by the amount of any unused passive activity credits that reduced the basis of such property for the tax year in which such credit arose. See section 469(j)(9). Unlike a suspended passive activity loss, which is deductible upon the disposition of the taxpayer’s interest in the activity, disallowed passive activity credits will not be able to be used after the disposition of the interest unless the taxpayer has passive income from other activities. Accordingly, this election should be considered strongly by taxpayers with no other passive income.
It must be made by properly completing Part VI of Form 8582-CR, Passive Activity Credit Limitations, and submitting it with a timely filed return, including extensions, for the year of disposition. The election is irrevocable.
OTHER DEDUCTIONS AND LOSSES
Charitable contribution of capital gain property . Individuals can contribute appreciated capital gain property to 50% charities and obtain a deduction for its fair market value (FMV). However, the deduction is limited to 30% of the individual’s adjusted gross income without regard to any net operating loss carryback (“contribution base”). Any unused charitable contribution is carried over. Under IRC § 170(b)(1)(C)(iii) and Treas. Reg. § 1.170A-8(d)(2)(iii), an individual may elect to increase the limit on the charitable contribution deduction to 50% of the contribution base by reducing the deduction by the amount that would have been long-term capital gain if the property had been sold by the taxpayer for its FMV. The practitioner should compare the two methods, keeping in mind related issues such as phaseout of itemized deductions.
This election applies to charitable contributions of capital gain property made in the current year as well as carryovers from earlier years. It can be made by attaching a statement to a timely filed income tax return.
Reducing basis by items of loss or deductions for S corporation shareholders. Where losses and other deductions exceed the limit of an S corporation shareholder’s adjusted basis, an election can be made to alter the application of the ordering rules under Treas. Reg. § 1.1367-1. Normally, basis is first decreased by nondeductible, noncapital expenses (and certain oil and gas depletion deductions), then loss and deduction items. This treatment may result in deferring the deduction of losses and deductible expenses if the sum of all such pass-through items exceeds basis. Any deferred amounts are carried forward until sufficient basis is created.
The election (Treas. Reg. § 1.1367-1(g)) allows the shareholder to reverse that order. The election is made not at the entity level but by attaching a statement to the shareholder’s original or amended return. This election should be routinely but carefully considered, as it would not be beneficial in some instances.
While many states accept elections made at the federal level, before discussing these and other elections with clients during tax planning sessions, practitioners should confirm such treatment is available where a state income tax return will be filed.
By C. Andrew Lafond, CPA, DBA, (email@example.com) assistant professor, The College of New Jersey, and Jeffrey J. Schrader, CPA, (firstname.lastname@example.org) shareholder in Jeffrey J. Schrader CPA PC, Trenton, N.J.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at email@example.com or 919-402-4434.
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